The angst over FRDI Bill

Mythili Bhusnurmath

Senior consultant at National Council of Applied Economic Research

It’s  official! The government intends to stick to its guns on the contentious FRDI (Financial Resolution and Deposit Insurance) Bill. But if it thinks its assurance regarding the safety of bank deposits will be enough to assuage depositors' fears, it is completely out of sync with the ground realities. Indeed, the fact that the government is doggedly hanging on to a clause that should never have been there in the first place is only going to make matters worse. 

Ever since details of the Bill, at present being examined by the Joint Parliamentary Committee, became public knowledge, bank depositors have been a fearful lot. Remember, this is a government that, with a stroke of its pen, rendered as much as 86% of the currency worthless! Never mind that every currency note carries the solemn promise of the sovereign to give value for money! So what price an assurance by that bank on the safety of bank deposits, extended via Twitter, even if it is by a senior bureaucrat? 

“Bail-in will be only sparingly used. Public sector banks will effectively not be subject to bail-in provisions. Depositors need not have any apprehensions,” tweeted Secretary, Department of Economic Affairs, Finance Ministry, Subhash Chandra Garg. What is the common man to make of that? If public sector banks (PSBs) are not going to be subject to bail-in provisions, will private sector banks, which account for about 30% of bank deposits, be subject to bail-in provisions? If so, should depositors in these banks move their deposits to the PSBs? 

Importantly, what does “sparingly used” mean? Once there is a provision in the law, there is nothing to prevent a government, from exercising the power. Who will decide when the clause will come into play?

Sure, bail-in is applicable only to uninsured deposits. But deposits are insured only up to Rs 1 lakh (a level set way back in 1993), which means the bulk of bank deposits can technically be used to “bail in” a bank. The hard-earned money of the public that is deposited in a bank can be used to settle other dues in the event of bank failure. Thus, there is no guarantee you will get the money you deposited in the bank! 

Under the Bill, as it stands today, in the event of the failure of a bank, the Resolution Corporation (the designated entity under the Bill) can use depositors' money to save the bank from going under. This is in sharp contrast to the situation that exists today wherein taxpayer money is used to rescue a bank that is in trouble — as in the case of bank recapitalisation bonds.

So why is the government set on undermining depositors' peace of mind and, possibly, risking a flight of savings away from banks? Quite simply, because we love to ape the West! We blindly follow the advice of Western-educated policy advisers, many of whom are green behind the ears regarding ground realities in India. 

In the West, the genesis for similar legislation lay in the 2008 crisis when many financial firms failed and taxpayer money had to be used to bail them out. But the Indian situation is quite different. 

1 For one, the banking system in India is dominated by majority government-owned banks. In over two decades since banking sector reforms commenced, we have not had a single banking crisis (defined as the failure of multiple banks). The recapitalisation cost to the government is estimated at less than one per cent of GDP in over two decades, a miniscule cost compared to the median cost of 6.8 per cent of GDP, according to an IMF study of banking crises in free-market economies during 1970 - 2011. 

2 For another, unlike in the West where the bulk of bank deposits are raised from the wholesale market (money market mutual funds, certificates of deposits etc) and hence are in the nature of capital market investments, the bulk of bank deposits in India comes from retail depositors. The latter are willing to settle for lower returns (interest) on their savings only because they put a higher premium on safety. Unlike shareholders of a bank who benefit from any upside in its performance, bank depositors get only the contracted rate of interest. Hence, it is a travesty of justice to use deposits in the event of a downside. 

3 Again, unlike in the West, private sector banks (like their public sector counterparts) are much more closely regulated and supervised. Apart from mandatory capital, banks are required to maintain both a cash reserve ratio and a statutory liquidity ratio by way of abundant caution. For all its sins, and there are many when it comes to build-up of NPAs, the Reserve Bank of India has done the admirable job of ensuring no large bank goes belly-up. Apart from a few cooperative banks that have folded, there is not a single instance of a large bank going under.  

At its core, banking is about trust. True, even today bank depositors are essentially unsecured creditors of a bank. But the safety of bank deposits has always been seen as sacrosanct. Which is why every inspection report of the RBI invariably concludes by certifying the bank is in a position to pay its present and future depositors in full. 

So, even though the intent of the Bill — to create a consolidated framework for the resolution of financial firms, akin to the Insolvency and Bankruptcy Code for non-financial firms, by setting up a Resolution Corporation — seems harmless enough on paper, in practice it is anything but! By allowing the Resolution Corporation to resolve a financial firm by, among other methods, directing a bail-in (read, use of bank deposits) in the event of bank failure, it hits at the very edifice on which modern banking is built. By legalising the use of bank deposits in the event of bank failure, the FRDI Bill violates depositors' trust and does enormous damage. The clause in question must be scrapped.